Expectations Formation, Sticky Prices, and the ZLB

Elizabeth Bersson, Patrick Hürtgen and Matthias Paustian

Journal of Money, Credit and Banking, 2024, vol. 56, issue 2-3, 365-393

Abstract: At the zero lower bound (ZLB), expectations about the future path of monetary or fiscal policy are crucial. We model expectations formation under level‐k$k$ thinking, a form of bounded rationality formalized by García‐Schmidt and Woodford (2019) and Farhi and Werning (2019), consistent with experimental evidence. This process does not lead to a number of puzzling features from rational expectations models, such as the reversal puzzle, or implausible large fiscal multipliers. Optimal monetary policy at the ZLB under level‐k$k$ thinking prescribes keeping the nominal rate lower for longer, but short‐run macro‐economic stabilization is less powerful compared to rational expectations.

Date: 2024
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https://doi.org/10.1111/jmcb.13065

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Persistent link: https://EconPapers.repec.org/RePEc:wly:jmoncb:v:56:y:2024:i:2-3:p:365-393

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